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Is It Time to Short Best Buy Stock?

It seems big-box retailers are facing increasing competition from online retailers, so why the recent rallies for stocks like Best Buy? Is it time to short these inflated stocks, or is there another side to the story?

This year has brought us some stocks that have head-scratchingly doubled in value -- much to the displeasure of my CAPS score. As you can see in the chart below, Best Buy(NYSE:BBY), Angie's List, and RadioShack returned 113%, 103%, and 89% year to date, respectively. Compare those returns to a company that has made a real visible turnaround that will be discussed in future business classes: Ford, which has returned only 15%. While long investments in Best Buy, Angie's List, and RadioShack seem ridiculous, here are both sides of the argument on shorting Best Buy.

Bull/long argument One reason there's been hype from investors was last year's hire of CEO Hubert Joly -- a turnaround specialist -- who quickly listed Best Buy's largest problems. An obvious problem was "showrooming," where consumers browsed products in store with a more knowledgeable Best Buy staff and then proceeded to make the final purchase online for a cheaper price.

Best Buy recently unleashed a price-matching policy that should give incentive for consumers to just make the final purchase in the store. It's likely to be a good move to help stabilize same-store sales but will adversely impact already dwindling margins -- we just don't know how significantly yet.

A second reason for hype with investors is the move toward higher-margin products -- away from fading low-margin DVDs and CDs. With an increased emphasis on big-ticket items such as appliances, smartphones, and tablets, shareholders are hoping to see improving margins and profits. I think there's a huge caveat here, one that I'll address in the bear/short argument.

Lastly, Best Buy's balance sheet is typically discussed in many bear arguments. According to The Wall Street Journal, Best Buy's move to sell its stores in Europe back to Carphone Warehouse for roughly $775 million allowed it to improve its balance sheet -- helping to alleviate one of shareholders' biggest worries.

Is hiring a turnaround specialist who is attempting to reduce showrooming, increase emphasis on high-margin products, and shore up the balance sheet enough to justify Best Buy's rally? Will its focus on cost-cutting be enough? Here's why it might not be.

Bear/short argument Regarding that caveat I mentioned about Best Buy emphasizing higher-margin products such as smartphones and tablets: Apple(NASDAQ:AAPL) has already had success creating a direct-to-consumer store for its products and has basically shown other competitors it can work.

How long will it be before Microsoft and/or Samsung make the exact same move? If and when they do, it will adversely affect Best Buy in a couple of ways. Obviously, one is the increased competition for store traffic. Another more serious implication is the loss of pricing leverage, which Best Buy didn't have much of to begin with.

As Apple Stores gain more traction and presence, it will eventually increase Apple's margins enough that it can raise the price Best Buy must pay for its popular products. Best Buy would then find itself between a rock and a hard place. It could either keep its margin intact and raise its retail price or eat it to stay competitive and watch profits decrease. It's a lose-lose situation for Best Buy and it's only a matter of time before Microsoft and Samsung follow Apple in its direct-to-consumer approach.

That brings me to another point of significant worry for Best Buy profits: warranty sales. As each lost sale walks out the door, or never comes in to begin with, Best Buy not only loses the sale but its additional warranty sale. Consider that nearly a decade ago, according to Bloomberg, a healthier Best Buy was raking in profit margins on warranty contracts between 50% and 60% -- nearly half of its operating income, analysts estimated. Best Buy simply paid a small fee to insurers and then pocketed the rest directly to the bottom-line profits -- since products rarely needed replacement.

Those sales have been a large contributor to Best Buy's free cash flow, and most people forget that it's a significant part of each lost sale. Which brings me to yet another worry: Without a large cash flow contributor, how long is it before the dividend is canceled? Best Buy could already use the cash elsewhere to help fund its attempted turnaround, seemingly shortening the life of its current dividend.

Bottom line Best Buy is in a tough spot, and it seems the digital age is becoming rich with companies like Amazon.com that are producing valuable products or content and finding their own way to create profits rather than solely depending on retailers like Best Buy. While Joly is taking the right steps for a turnaround, I don't believe the future marketplace has a large enough home for Best Buy with so much competition from all angles.

Let's not forget that the company has zero earnings on decreasing revenue, ballooning debt, and little cash flow -- there isn't much I like right now. I'm not shorting anything in this current market rally, but when I do, Best Buy is at the top of my list. That's just my take on it -- what's yours? If you're confident in a Best Buy turnaround, tell me why in the comments box below.

Author

As a Motley Fool Industrial Specialist, I use my marketing and business background in the automotive industry to evaluate major automakers and other large industrial corporations. Follow me on twitter for tweets about stocks, cars, sports, and anything I find amusing.
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